Don't bet your shirt on a repeat performance.
That's the message from some of the nation's biggest investment firms as the Dow Jones Industrial Average has closed above 16,000 for the first time and the Standard & Poor's 500 index is on the cusp of its best year in a decade with a gain of 25.9 percent.
Although investment professionals still are optimistic, investors shouldn't expect such outsized gains will be repeated.
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The S&P 500, the Dow and other stock indexes have risen steadily as the Federal Reserve has maintained its economic stimulus to keep long-term interest rates low, and the economy has continued to strengthen. Although economic growth hasn't been spectacular, it has been strong enough enable companies to keep increasing their earnings.
On the outlook for stocks
A double-digit gain is not out of the question.
Many of the tail winds for the stock market are still in place, but they may start to weaken next year. Corporate earnings are strong, but profit margins could be peaking. Interest rates are still low compared to historical levels, but will likely rise gradually, particularly if the Fed starts to pull-back on its bond-buying stimulus program.
However, the biggest challenge to the stock market is that valuations have risen so much this year, says Larry Puglia, portfolio manager of T. Rowe Price's Blue Chip Growth fund. That is to say, investors have been willing to pay more for a company's future earnings, pushing up prices. The price-earnings ratio for S&P 500 companies has risen to 15 from 12.5 at the start of this year, according to FactSet.
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"We still find selected stocks attractive and think that the market's OK, but I would be surprised if the market....was able to duplicate the type of gains we've had this year," says Puglia. He still thinks stocks could rise as much as 10 percent.
Conrad Hermann, a portfolio manager at Franklin Templeton says that statistics show that when the market logs an annual gain of 20 percent or more, it has been followed by another year of gains on two out three occasions -- for an average gain of 11.5 percent the next year.
On the best industry to invest in
Technology companies are the big favorite.
The tech industry should benefit from rising spending in an improving global economy, says BlackRock's chief investment strategist Russ Koesterich. He also says that technology stocks are typically less sensitive to rising interest rates than other industry groups are.
Many tech stocks don't pay a dividend, making them less sensitive to higher bond yields, and with strong new products they should grow profits. That suggests if interest rates climb, tech stocks should perform better than the overall market.
Tech companies are also less richly priced than some other parts of the market, while still offering good growth prospects. Those in the S&P 500 are trading at 14.4 times their projected earnings over the next 12 months. That makes them less expensive than health care stocks, which are priced at 16.7 times expected earnings, and industrial companies, which are valued at 16.1 times earnings.
On a reduction of fed stimulus
Investors have been obsessed with the Fed all year and the stock market's biggest setbacks have come when they thought that policymakers were poised to cut back on economic stimulus.
The S&P 500 has dropped in only two months this year, June and August. In both months investors sold stocks on concern that the Fed was about to stop its stimulus.
Instead, the central bank surprised investors in September by continuing its stimulus and now investors are getting more accustomed to the idea the Fed's efforts must end at some point. Sure, there may be a knee-jerk reaction when the Fed acts, but it won't last. Ultimately investors will see the end of stimulus as a sign that the economy is continuing to improve. Fed policymakers have also stressed that the end of stimulus will not necessarily be immediately followed by higher interest rates.
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"It will be a positive signal to the market that the economy can stand on its own two feet and doesn't need this super aggressive Federal Reserve action," says Puglia of T. Rowe Price.
On the biggest risks
Unsurprisingly, the dysfunction in Washington is still at the forefront of investors' minds. The 16-day partial government shutdown in October hurt consumer confidence and crimped economic growth. A repeat of that political wrangling next year would likely hurt the economy again.
Stocks are also vulnerable to a sharp rise in interest rates. The market's rally from its lows in March 2009 has been underpinned by low interest rates which has made stock market returns more attractive. If bond yields were to rise suddenly the economy would suffer.
The Fed's policy is predicated on buying bonds to hold down interest rates. If investors get nervous as the central bank cuts its bond purchases, removing a support for the market, bond yields could jump as investors dump bonds.
"If interest rates were to (go) back up dramatically that would probably be a bad thing," says Franklin Templeton's Hermann. "We're still in a very fragile economy and we don't want to suddenly tilt into another recession."
—By The Associated Press